Question

Board Member states that the cost of equity is the most expensive part of the capital structure. The rest of the board agrees and you hear some other talk, some of which you try to decipher. Which answer do you think is most accurate.

a. Common equity is most expensive because it gets paid off after bonds and hence riskier.

b. Common equity holders own the firm which entitles them to distributions of profits, so other providers of capital are giving up this advantage.

c. Common equity holders have unlimited upside in return potential whereas bonds do not.

d. The cost of equity to the firm is the required return to the equity investor. As such, all of the above are essentially true.

e. All of the above

Answer 1

Solution:

The most accurate statement is :

a. Common equity is most expensive because it gets paid off after bonds and hence riskier.

b. Common equity holders own the firm which entitles them to distributions of profits, so other providers of capital are giving up this advantage.

c. Common equity holders have unlimited upside in return potential whereas bonds do not.

d. The cost of equity to the firm is the required return to the equity investor. As such, all of the above are essentially true.

Hence option e "All of the above" is correct.